Nobody wants to pay more taxes than they must. For self-employed business owners, who pay both sides of employment taxes, this is especially true.
Let’s see if the following entity formation can help you hang onto more of the dollars you make. We’ll meet Mr. Attorney, an attorney at law who has never done much planning with regards to his tax filing status.
My accountant has mentioned that I could lower my taxes by switching to an S Corporation, but I've never made the time to look.
I don't want this to complicate my life. I have enough headaches as is with my practice.
Let’s look at how a simple entity change could help lower the Federal Insurance Contributions Act (FICA) tax that Mr. Attorney would owe.
How could an entity change provide Mr. Attorney over $7,500 in tax savings? Simply put, the S corporation allows Mr. Attorney to lower the amount of his wages that are subject to taxation.
Specifically, we are talking about the 2 taxes that make up the FICA tax. Those are Social Security’s Old-Age, Survivors, and Disability Insurance (OASDI) program tax and Medicare’s Hospital Insurance (HI) program tax.
First, let’s look at how OASDI and HI work.[1]
6.2%
OASDI for Employees
6.2%
OASDI for Employers
12.4%
OASDI for Self-Employed
$137,700
Of Wages up to the Contribution and Benefit Base
1.45%
HI for Employees
1.45%
HI for Employers
2.9%
HI for Self-Employed
Of all Wages with no maximum
Okay, now that we know how these taxes apply to Self-Employed individuals, like Mr. Attorney, let’s look at the amount of Mr. Attorney’s wages that would be subject to each tax as a Sole Proprietorship versus as an S corporation. Remember that Mr. Attorney had income of $200,000 for the tax year and the less of this income subject to taxes, the better!
The Magic of an S corporation is that it potentially allows an owner to reduce the amount of their wages subject to FICA taxes.
How is this possible though? This is due to the change in owner payment methods. In a Sole Proprietorship, all profit goes onto the owner’s personal 1040 and is considered wages. In contrast, an S corporation owner decides what their wages will be. That’s right, as an owner of an S corporation, you set your own wages! What happens to money in excess of that? Remaining profit, if any, will be taken onto the owner’s personal 1040 as a dividend from the S corporation.
What’s so special about an S corporation’s Dividend? [2]
Clearly, S corporation dividend income is among the best types of income to receive! Returning to our attorney, the obvious path forward for Mr. Attorney would be set his salary to $0 and take all the profit as S corporation dividend income. However, the Internal Revenue Service (IRS) takes a very dim view of this particular disappearing act. They have said that owner compensation must be “reasonable”, and, in the event of abuse, they have the right to recharacterize dividends as wages with additional penalties! Thus, you must be prudent in deciding what your wages will be as a S corporation owner.
In general, “reasonable” is what you would have to pay an employee to replace the services you provide to the business. You do do many things as a business owner that are not related to the core business you provide, so ignore those, and imagine that you had an employee providing the core services your business provides. What would you pay this person? Likely, you’d examine what other businesses in the area are paying people for similar work. You’d compare several groups, examine your work culture in comparison to theirs, and settle on a fair offer. This, then, is the starting point for determining reasonable wages.[3]
In the case of Mr. Attorney, he looks to www.salary.com and notes that the median wage for an attorney in Fort Worth, Texas is $94,811. Deciding that he is above the median, and preferring round numbers, he thinks that $100,000 annually is reasonable wage for himself. He seeks out advice from his tax advisor who guides him through a prudent process to refine this, and they document the process utilized to arrive at their final decision.[4]
While there will be new tax forms required of Mr. Attorney, such as an 1120-S, his accountant will handle these items. Thus, we’ll be focusing on the work that falls on Mr. Attorney, namely, bookkeeping and payroll.
Like any reasonable business owner, Mr. Attorney already keeps books for himself. Now, though, he needs to formalize things a bit more to satisfy an informational tax return. Perfunctorily, this means he’ll have to maintain a Profit and Loss Statement and a Balance Sheet.[5]
The Profit and Loss Statement, often called an Income Statement, tracks 2 things:
These accounting items are commonplace for any business, and there are a litany of services and software that can aid you with them from templates in Microsoft’s Excel to online solutions. In fact, you likely have these items already, if only informally, via your bank account. More so, odds are that your current accountant can produce these for you with the information you already provide them.
Of course, if you’d prefer the easy way, you can always hire a payroll service, as there are many wonderful and affordable online solutions to take on this process! For Mr. Attorney, being a solo operator, pricing may be as low as $500 annually.
Mr. Attorney had 2 goals when he reached out, Reduce Taxes and Keep it Simple.
Mr. Attorney said that if this was going to be another job for him, it wouldn’t make sense. Fortunately, by working with his accountant and a new payroll service, Mr. Attorney was able to Keep It Simple and reap the benefit of his Total FICA Tax Reduction.
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